Small-cap Equities. The diamonds in the rough

By Adam Lloyd, Capital Markets

It’s all about the trade-off between risk and reward. In uncertain times, and we are most definitely living in uncertain times, financial markets lose their appetite for risk in a major way. The most obvious effects of that are falling share prices and rising gold prices. 

In times of peril, gold has always been a reliable store of value so it should be no surprise to see its price hit historic highs in recent months – peaking at US$2067 per troy ounce in August.  With the exception of the US equity indices, the world’s stock markets are still trying to recover from the global crash. In his excellent blog (here ) Bob Huxford looked at the astonishing rise in the value of tech companies like Apple, Google, Amazon and Tesla which have driven US markets to all-time highs while the recovery in the rest of the world’s markets is still very muted.

So, tech stocks and their crazy values aside, the financial markets are pretty much as you would expect as the full economic impact of the pandemic unfolds and we all wait desperately for a vaccine so we can get back to normal.

Equity risk is not just a function of a company’s particular circumstances but also the ability of shareholders to open and close positions to suit their own requirements. In effect, liquidity alleviates risk by allowing the quick and easy transfer of stock between buyers and sellers. A liquid market attracts more investors and increases values while, inevitably, the opposite is true without liquidity. 

What creates and sustains liquidity is the subject of timeless debate but it is safe to say that first and foremost, it is a function of size. A large company with lots of shareholders will have greater liquidity than a small company with just a few shareholders. As you move down the market cap scale you are entering a downward spiral of fewer investors, less liquidity and lower values.

There is no hard and fast rule but most of the large institutional investors won’t invest in companies with a market capitalisation below £100 million. There are many specialist small-cap funds that routinely invest below £100m but they too have a lower limit. Below £25 million things get very tight with institutional investors in very short supply, especially now, when fund managers are doing all they can to reduce the risk in their portfolios. Today the FTSE AIM All-share index has 721 constituents, 500 of which are below £100m and more than 300 below £25m. With little or no apparent institutional appetite for their shares what do these companies do? Many will be sound, well managed businesses with excellent prospects and a need for equity capital to fund their growth.

So back to the risk reward trade off.  

If fund managers are turning their backs on small-cap shares because of low liquidity it may be argued that the perceived increase in risk is driving down values but also increasing the potential rewards. Back in the early 2000s, Unicorn Asset Management was founded on that very principal: they utilised a bottom-up approach to identify unloved and under-valued growth companies which were not well known or appreciated by the wider market. They still employ this approach today and have successfully grown to over £1.3 billion AUM, so we know it works.

For all those companies listed on AIM that feel unloved and unsuitable for institutional investors the message is “keep the faith”. Markets are operating at extremes because no one really knows what will happen next. The world keeps turning and good businesses will always have their day. While values are being artificially depressed by the move from risk there is a great opportunity for investors willing to do the work to understand a business and take the plunge. Managements should be taking every opportunity to make their business accessible and easy to understand. With over 500 companies effectively below the institutional threshold there is plenty to choose from so it is important to make your business stand out.

For investors willing to make the effort and follow the Unicorn lead this is almost a once in a lifetime opportunity.

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